Investing Basics: Factors that impact currency exchange rates

 

Explaining currency exchange rate movements is still a challenging task, even for experienced economists. The reason for this lies in the multitude of factors that influence exchange rates on an intraday, monthly and yearly basis, which can sometimes be hard to identify and pinpoint – by Phillip Konchar

Still, traders who rely on fundamental analysis can take advantage of a comprehensive approach to fundamental determinants which are outlined in this article. We’ve grouped these determinants into short-term, medium-term and long-term factors to make it easier for you to follow their impact on exchange rate movements.

 

Short-Term Factors

 

Short-term factors influence exchange rates on an intraday and daily basis. Many economists argue that exchange rates are made up of market noise in the very short term, but traders have still found valuable tools that help in explaining those moves – although with various success. Since currencies essentially move on the changing dynamics of supply and demand, these factors may be helpful in determining whether a currency will experience increased demand or supply arising from market participants.

 

Risk Appetite

 

Risk appetite is among the most important short-term exchange rate determinants. Improving risk appetite increases demand for riskier currencies, such as the New Zealand dollar, Australian dollar, euro or emerging market currencies. If risk appetite deteriorates, market participants will relocate their capital into so-called safe-havens or ports of last resort, such as gold, the Japanese yen, the Swiss franc or the US dollar. Take for example a falling stock market in the United States – this will most often lead to an appreciation of the US dollar as investors start to reduce their exposure to equities and increase their cash holdings.

‘risk appetite changes from hour to hour’

Since risk appetite changes from hour to hour, traders can use currency heat maps to identify whether risk appetite is improving or deteriorating. A classic risk-off market environment implicates a rising US dollar against all majors except the Japanese yen which rises across the board, combined with falling risk currencies such as the New Zealand dollar and Australian dollar.

 

Investor Sentiment & Positioning

 

Investor sentiment and positioning are closely related to risk appetite in the market. Investors will have a bullish bias on safe-havens and a bearish bias on risk assets if the risk appetite is decreasing, which leads to adjustments in investor positioning and increased exposure to safe-havens.

Traders can follow investor positioning by the Commitment of Traders report, released each Friday by the CFTC. The CoT report shows the market positioning in certain currencies, including net short and net long holdings by market speculators. As market participants increasingly buy or sell a currency, that currency rises or falls accordingly.

 

Trend-Following Behaviour

 

Last but not least, trend-following behaviour has a significant impact on exchange rates in the short-term. This determinant is closely related to technical analysis, as certain technical levels may attract buyers and sellers in the market and cause the exchange rate to move.

‘trend-following behaviour has a significant impact on exchange rates in the short-term’

If a growing number of investors see a trend forming, they will join the market, essentially causing the trend to accelerate. This, in turn, attracts fresh capital, which accelerates the trend even further. This is the power of the crowd.

 

Medium-Term Factors

 

Medium-term factors influence exchange rates over the course of a few weeks to a few months. These factors are often related to changes in a country’s monetary and fiscal policies; increased capital flows into an economy and the relative economic growth between two countries.

 

Monetary & Fiscal Policy

 

Changes in the monetary and fiscal policy of a country have a tremendous impact on exchange rates. Even the slightest hints of monetary tightening or loosing will cause that currency to appreciate or depreciate, respectively.

‘central banks lower interest rate to spur economic activity and inflationary pressures’

Central banks hike interest rates when economic growth and inflation rates show signs of overheating, which in turn lifts borrowing costs and slows economic activity and inflationary pressures down.

Similarly, if the economy is struggling and inflation rates are stubbornly low, central banks lower interest rate to spur economic activity and inflationary pressures. Increased public spending and a looser fiscal policy increases demand for the domestic currency, which in turn causes the currency to appreciate.

 

Capital Flows

 

Closely related to changes in monetary policy are capital flows. Since high interest rates are more attractive than low interest rates, international capital will flow into those currencies which carry the highest interest rates. This, in turn, causes that currency to appreciate. Take the US Fed for example. At the time of writing, the Fed was the only major central bank that had a clear path of monetary tightening for the coming period, as the US economy performed strong and inflation rates remained high. This caused the US dollar to outperform against all major currencies in the second quarter of 2018.

 

Relative Economic Growth

 

Relative economic growth between two countries is another important medium-term determinant of exchange rate movements. If a country has a better performing economy than another country, chances are that its currency will experience increased demand. Higher economic growth also raises the chance of monetary tightening, which increases demand for the respective currency even further.

 

Long-Term Factors

 

Contrary to public opinion, getting the exchange rate right in the long-term may be the most difficult task.

‘the equilibrium exchange rate of a currency pair can change on a daily basis’

The reason for this lies in the ever-changing currency fundamentals – the equilibrium exchange rate of a currency pair can change on a daily basis with changing fundamentals, which in turn means that a currency pair will never reach yesterday’s equilibrium rate in the first place. Long-term currency valuation is based on a time horizon of multiple months to multiple years.

 

Purchasing Power Parity Model

 

In an attempt to forecast exchange rates in the long-term, economists have developed various currency-valuation models that try to derive the equilibrium or fair exchange rate of a currency pair.

One of the most popular long-term currency-valuation models is the Purchasing Power Parity model or PPP. The PPP model suggests that the purchasing power of two currencies has to be the same in the long-term, i.e. the currency with the lower purchasing power has to appreciate, while the currency with the higher purchasing power has to depreciate.

Take for example a luxury car that costs € 100,000 in Germany and $120,000 in the United States. This implies an equilibrium exchange rate of the EUR/USD pair of 1.20.

If the current exchange rate is 1.40, a potential buyer from Germany may fly to the United States and buy the same car for roughly € 85,000 (by exchanging €85,000 to $120,000 at a 1.40 exchange rate).

If many buyers do the same, the increased demand for US dollars should eventually cause the exchange rate to fall to its equilibrium exchange rate of 1.20.

Obviously, while the PPP model makes sense, it’s still a vague concept. Our German buyer will have to pay for an airplane ticket, pay for a hotel room in the USA, pay transportation costs to ship the car to Germany, and most probably pay import tariffs once the vehicle arrives in Germany. These reasons reduce the incentive to buy the car in the United States instead of in Germany.

While this was a very simple example, the PPP model had some impressive results in the past. The well-known Big Mac Index, developed by The Economist, uses the PPP model to forecast exchange rates based on the price of McDonald’s Big Macs.

When the euro was invented back in 1999, many economists believed that the new European currency would attract foreign capital and appreciate against the US dollar in the coming years, with one notable exception – the Big Max Index.

The Index suggested that the single currency was overvalued against the US dollar in 1999, based on the prices of Big Macs in Europe and the United States. Interestingly, the EUR/USD pair was indeed falling for the first two years to reach a low of around 0.9 in 2001, before rising to 1.30 in 2003.